Thursday, January 31, 2008

The Lawson Boom of the late 1980s

Between 1985 - 1988, economic growth was well above the long run trend rate of 2.5%. By 1990, inflation had increased to 9.5%.

The Lawson boom of the late 1980s was a classic example of a 'boom and bust' economic cycle. The late 1980s were a period of rapid economic expansion. This was caused by rising house prices, tax cuts, lower interest rates and high confidence. However, the boom cause a rise in inflation and a larger current account deficit.

Policies to tackle this inflation caused the recession of 1991-92.

The Lawson boom followed from the devastating recession of 1981. This recession particularly affected the manufacturing sector, and caused unemployment to rise to 3 million. By 1985, unemployment was still over 2.5 million people. However, from 1986 the government made various decisions which helped to inflate the economy causing an inflationary boom.

Causes of the Lawson Boom

Tax Cuts

In 1988, the chancellor Nigel Lawson reduced the basic rate of income tax from 29% to 25%. The higher rate of income tax was cut to 40%. The tax cuts were so large, the 1988 budget is often referred to as the 'giveaway budget'.

The effect of these tax cuts was a fiscal stimulus which helped to increase disposable income and consumer confidence. This led to a rise in consumer spending and economic growth.

Over Optimism

During the 1980s, the government felt that they had presided over an 'economic miracle'. They felt that the last recession had removed a lot of inefficient firms. They also felt that supply side policies, such as privatisation, had been effective in increasing the productivity of the economy, and therefore had increased the long run trend rate of growth. This belief in their own success encouraged them to believe the economy could grow at a much faster rate than previously. Therefore, when growth increased above 4%, they did little to slow down an overheating economy. They believed (or hoped) that the long run trend rate of economic growth had miraculously increased from 2.5% to 4%. As Nigel Lawson said in his budget speech 1988.

In 1987 as a whole, output grew by getting on for 4½ per cent., rather more than the rate of inflation which averaged 4.2 per cent. At the same time, unemployment fell faster than in any other year since the war, in every region of the country, and more than in any other major nation.
The plain fact is that the British economy has been transformed. Prudent financial policies have given business and industry the confidence to expand, while supply side reforms have progressively removed the barriers to enterprise. (source)

However, this was not the case. The economic miracle had failed to materialise.

A Reluctance to Increase Interest Rates

In the 1980s, interest rates were set by the Chancellor (not the independent Bank of England, like now) In October 1987 there was a stock market crash. In one week 25% of the stock market value was wiped out. There was no obvious economic cause of this. But, the government was worried of its macro economic implications. As a result interest rates were reduced, to avoid any downturn. As it happened the stock market crash had little macro economic effect and the economy continued to grow very fast.

Exchange Rate Mechanism ERM

This was another factor keeping interest rates lower than they should. Mrs Thatcher didn't want to join the ERM, however the Chancellor Nigel Lawson wanted to follow an unofficial exchange rate of 3 DM to £1. This often proved to be a factor in preventing interest rates from rising. The Chancellor didn't want to increase interest rates because it would break the 'unofficial exchange rate'

The Housing Boom

The relatively low interest rates and the high consumer confidence sparked a housing boom. During the boom years, house prices rose by 300% (and more in places like London). Q4 1988 was the peak of the boom period with house prices rising over 30% at an annual rate. This boom in house prices caused a rise in household wealth and increased confidence. Equity withdrawal rose to record levels, which helped increase consumer spending.

Rising interest rates meant mortgage payments in the late 1980s took over 50% of disposable income

By 1988 and 1989, the economy was growing at 5% a year (almost double the long run trend rate) Despite signs of overheating, the government were reluctant to react. Interest rates were increased, but not as quickly as they could have. Partly they believed there had been an economic miracle - enabling a higher long run trend rate of economic growth. But, also Nigel Lawson, didn't want higher interest rates to boost the value of the Pound above the 'unofficial exchange rate' he was following. This was a policy known as shadowing the D-Mark. However, the fast growth meant that inflation started to creep up, eventually reaching 11% in 1990. With inflation at 11%, interest rates were increased further, but this caused mortgage payments to increase and the confidence evaporated as many people found they couldn't afford the mortgage repayments.

Current Account Deficit

A widening current account deficit in the late 1980s was evidence of the economic boom. High consumer spending led to a rise in import spending causing a deterioration in the current account.

Higher growth led to a bigger current account deficit. In 1989, the current account was 4.9% of GDP - reflecting the fact the economy was overheating and consumers were buying from abroad.

2 comments:

adrian rayner
said...

Everyone has a personal view, good commentators present a balanced view. It is noteworthy that you split Thatcher's rule into two parts, "The UK Economy under Thatcher from 79 - 84" which you dismiss as a recession, and "The Lawson Boom of the late 1980s", equally pejorative. I assume you did not vote for Mrs Thatcher? Whilst the data in your articles is true, you should also mention the positive effects of all her reforms, including:- Dismantling of Unions that had crippled UK- "small government" ethos(compare to today!)- low taxation (top rates of 99% during 1970's) - vastly improved workplace legislation (now taken away by Brussels)resulting in much inward investment (in marked comparison to much of Europe, still badly in need of reform)- Euroscepticism, and prophetic warnings on the insanity of Euro- All the above encouraging businesses

UK was a mess when Thatcher took over. No economy is ever perfect, and all leaders including her leave a mess, but the mess she left was substantially better than the mess she inherited